A Chief Investment Officer’s primary responsibility is to identify and clearly communicate his/her portfolio’s risks to his/her Board, Investment Committee and/or client(s). About eighteen months ago, the University of Texas Investment Management Company (UTIMCO) developed a ten item framework to help with this responsibility.
The first risk we highlighted is the risk of underperformance. Precisely because this risk is typically not the first risk that is thought of, coupled with the reality that if not for this risk no other risk need be borne, we placed it at the beginning.
Of course, in order to identify this risk the required/desired performance must be clearly known. Generally the required performance is the distribution rate plus inflation, although even this seemingly straightforward objective requires additional specificity as to time frame and inflation measurement, much less the required or desired distribution rate. And many a client and/or boss really thinks the required performance is the greater of the distribution rate plus inflation, market returns or competitor returns. Good luck nailing down the definition of performance! But try we must.
Given a performance requirement, the second risk we articulated is market risk. Cash simply will not earn enough to satisfy distribution rates plus inflation, so exposure to other capital markets is required. Such exposure can cover a broad range of markets from bonds to commodities to real estate to equities, each present in numerous varieties. Every capital market, however, carries with it specific risks, often times including, but not limited to, interest rate exposure, duration, cash flows, earnings, asset values, counterparties, exchange rates and a myriad of other factors. A thorough and detailed understanding of each specific market’s risk factors, combined with correlations across market risks, is a starting point for understanding a total portfolio’s inherent market risks.
Participation in capital markets guarantees some element of the third risk we addressed: volatility. Many investors have come to associate with volatility as the definition of risk. We are not among that group. When someone uses the phrase “risk-adjusted” they are usually speaking about “volatility-adjusted”; we think one should be clear about the difference.
In fact for us, because an endowment arguably is the longest term of investors, volatility is something that we should be able to take advantage of, not be troubled by. On the other hand, while our portfolios are in perpetuity, our jobs are most certainly not.
Therefore, we need to be cognizant of volatility risk and careful to communicate it to our bosses and clients in order to have the best chance of keeping our jobs and producing stellar long term results. Educating bosses and clients on the basics of probability theory based on empirical data, therefore, is one necessary part of our job.
A second element inherent in capital markets is the fourth risk which we have dubbed scenarios. Said in other words, the unexpected should be expected and bad things can (and will) happen. Things that may, or may not, be different from what we have already experienced.
We look at what we think will be the effect on our portfolio of economic changes (e.g., interest rate increases, inflation, deflation, etc.), previous market events (e.g., Black Monday, the Lehman crash, sustained bear markets, etc.) and conceivable future events (e.g., hard landings, oil price changes, monetary miscues, etc.). Our goal for this analysis is to think about potential portfolio repositioning (which, candidly, are rare) and, more importantly, what our response would be should such an event arise.
We are given the challenge of underperformance risk and therefore compelled to assume market risk with its inherent volatility and scenarios. We choose, however, to take or not take the fifth risk: active management.
Most of us have chosen to take active management risk; some of us are correct in doing so. The key question here should not be “do I feel lucky” but rather “what makes me think I’m good”. Our view is that active management is difficult and that skill matters in investing. A clear delineation of the perceived “edge” that the investing organization brings to bear is essential.
UTIMCO’s belief is that we can identify and partner with skilled practitioners around the globe who are focused on specific capital markets. We believe we can do so because of our asset size and staff quality. We believe it is very difficult to do so, requiring constant, patient and disciplined effort.
Our sixth risk is transparency. Because our business model is to partner with external investment managers, with varying degrees and timeliness of security-level disclosure, we do not always know precisely what we own.
This is a risk we are willing to bear in order to partner with the best, although we look to mitigate this risk through initial and ongoing diligence and dialogue with our partners. Their interest in communicating with us is enhanced not only by our asset size but by the quality of our staff and thus the quality of the two-way discussions we are able to have.
Concentration risk is the seventh we list and, like most risks, too little can be as challenging as too much. We measure many different aspects of concentration, including geographic, sector, manager, and security level concentration.
Like many portfolios I suspect, we may be overly diversified although we have not yet determined what an optimal level of concentration would be. Concentration can be a double-edged sword: wonderful when it works but wounding when it doesn’t. We continue to focus on better understanding this risk in order to optimize its expenditure.
Our “lucky eight” risk is illiquidity. Lucky because for us this is an inherent competitive advantage vis-à-vis other capital pools that are not in perpetuity.
Again, a “Goldilocks” approach is optimal: expend the risk if and when appropriately rewarded and never in excess of the portfolio’s ability to “weather a storm”. We’ve devoted a fair amount of time analyzing illiquidity issues, and we continue to spend a good amount of time and effort tracking illiquidity exposure and returns.
Number nine is leverage. As Howard Marks (as usual) insightfully observes: leverage does not make an investment (or portfolio) good or bad; it simply makes a good investment better and a bad investment worse.
We tend not to deploy leverage at the portfolio level. We also prefer public equities with strong balance sheets, hedge funds with very manageable grosses, and we tend to shy away from highly leveraged private investments. Call us old fashioned.
Finally, our permanent loss of capital is our tenth risk. I must admit that I’ve never met an investor yet that believes they will lose all their capital at the time they are making the investment. Therefore, I find the “permanent loss of capital religion” only somewhat helpful. That said, we do have a “value” bent and who doesn’t like a margin of safety.
We do track and analyze permanent loss of capital and, for the record, ours is quite low. Perhaps too low. Remember, even banks have loan losses.
I hope this framework is helpful. While I know that it is not revolutionary or worthy of publishing in a truly academic journal, perhaps it will prove useful for the practicing CIO just trying to understand and communicate risks that we all must do our best to manage.